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2/15/2021 Investing in Mutual Funds and Real Estate
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13.1 What Is a Mutual Fund?
LEARNING OBJECTIVE 13.1 LEARNING OBJECTIVE 13.1
Distinguish different types of investment companies based on
key characteristics.
In the Feature Story, José and Maria were able to invest in
stocks and bonds without having to make the individual
investment selections themselves.
You can do this by purchasing shares of an investment company
that pools small dollar amounts from many investors and invests
those funds in a wide
variety of assets. Each investment company must provide
detailed background information for potential buyers, including
the company's investment
objectives, holdings, and track record.
Investors like José and Maria buy shares in the investment
company, and the company uses the dollars to make investments
on behalf of the investment
pool. The term mutual fund is often used to refer to all types of
investment companies, but technically, a mutual fund is a
specific type called an open-
end investment company, which we explain later.
Although the mechanism can differ across funds, the cash flows
generated by the securities in the investment pool are later

distributed to the investors.
As with stock investments, this distribution can take the form of
dividends or an increase in the value of investment shares.
Investors who purchase
shares in mutual funds are like other corporate shareholders—
they have an equity interest in the pool of assets and a residual
claim on the profits, but
they have no say in day-to-day decisions about buying and
selling the financial assets.
Until the enactment of comprehensive securities laws in the
1930s, investors didn't have a lot of confidence in this type of
investment. Today, however,
mutual fund shares are considered securities under the legal
definition of the word, and shareholders are therefore entitled to
all the protections afforded
to owners of other financial assets. That means the investment
company must provide all potential investors with detailed
disclosure information, much
like the information you'd get for a stock or bond investment.
The company also must make regular reports to the Securities
and Exchange Commission,
which regulates mutual funds.
In this section, we first take a closer look at the mutual fund
investor's ownership interest, usually measured as net asset
value. You'll learn about the
various types of investment companies and the advantages and
costs associated with mutual fund investing.
What Does a Mutual Fund Investor Actually Own?
One measure of the value of an investor's claim on a mutual
fund's assets is called the net asset value. This is calculated as
assets minus liabilities, per
share, as defined in Equation 13.1:
(13.1)

For example, suppose you own one share of a mutual fund that
has 5 million shares outstanding. The fund portfolio is currently
worth $100 million, and
its liabilities include $2 million owed to investment advisors
and $1 million in rent, wages, and other expenses. Your net
asset value is therefore:
()
If the securities that are held in a mutual fund increase in value
or pay dividends, the net asset value of the shares of the mutual
fund should also increase
in value, even though these increases are technically unrealized
capital gains. The objective of fund managers is therefore to
invest in assets that will
continue to grow in value over time. This is an important point
to keep in mind as you learn more about this type of
investment—mutual fund values
will tend to track the performance of the assets they invest in.
So if the stock market is down, mutual funds that invest in stock
will typically decline in
value as well, because the assets they have invested in will have
lower market values. Demonstration Problem 13.1 shows how to
calculate net asset
value.
DEMONSTRATION PROBLEM 13.1 Calculating Net Asset
Value
Problem
You want to calculate the net asset value for the Acme Balanced
Growth and Income mutual fund. You have the following

information from the January
1 balance sheet:
Assets: $150 million
Liabilities: $10 million
Shares: 12.3 million
Strategy
Use Equation 13.1 to calculate net asset value.
A mutual fund investor earns a return on their investment in the
same way as stock and bond investors. They are paid dividends
on their shares, and they
benefit from an increase in the net asset value of their shares
over time. As you learned in previous chapters, the rate of
return on investment will be
. Suppose you bought the shares described in Demonstration
Problem 13.1 for $11.38 per share
and received a dividend during the year of $0.50 per share. If
the shares are worth $12.50 one year later, you have earned a
return of
or 14.24%.
Types of Investment Companies
Although different types of investment companies are often
lumped together in a discussion of mutual funds, the Investment
Company Act of 1940
identifies several distinct types that provide pooling
opportunities for individual investors. Types of investment
companies include open-end funds,

closed-end funds, exchange-traded funds, unit investment trusts,
and real estate investment trusts.
Open-End Funds
By far the most common type of investment company, an open-
end fund is different from the other types discussed in this
section in that: (1) it is
required to buy back shares any time an investor wants to sell,
and (2) it continuously offers new shares for sale to the public.
As mentioned above, the
term mutual fund typically refers to this type of investment
company.
With open-end funds, the share price for purchases and sales is
usually the net asset value plus trading costs. The issuing
company provides the only
market for the shares, and there is no secondary market for
trading between investors. The investment company is free to
issue new shares at any time to
raise additional funds for investment and to meet investor
demand for the shares.
Open-end funds can be very large, with many billions of dollars
under management. This is the type of fund that is commonly
available through
employer-sponsored retirement plans. As more dollars flow into
an open-end fund from retirement plan sponsors, the fund
creates more shares and
invests in more securities.
Closed-End Funds
A closed-end fund is an investment company that issues a fixed
number of shares that trade on a stock exchange or in the over-
the-counter market. The
process of issuing shares is very similar to that discussed in

Chapter 12 for stocks. The initial public offering of shares is
sold directly to investors, after
which the shares trade between investors in the secondary
market. Like open-end funds, closed-end funds hire professional
managers to use investor's
money to buy a diversified portfolio of assets that will meet the
investment objectives described in the fund prospectus.
Closed-end funds trade primarily on major stock exchanges,
such as the New York Stock Exchange and the NASDAQ. The
market values of shares
traded on the secondary market fluctuate with supply and
demand and may be greater or less than the net asset value per
share. Closed-end funds make
up only a small proportion of the total number of investment
companies (around 500 in the United States, compared with
more than 9,000 open-end
mutual funds) and are declining in popularity relative to their
close cousin, the exchange-traded fund.
Exchange-Traded Funds
An exchange-traded fund (ETF) combines some of the
characteristics of open-end and closed-end funds. It is
technically an open-end fund because the
company is free to issue new shares or redeem old shares to
increase or decrease the number of shares outstanding. But like
a closed-end fund, an ETF is
traded on an organized exchange, and share prices are
determined by market forces. Investors buy ETF shares through
a broker just as they would
purchase shares of common stock of any publicly traded
company.
Although the number of ETFs is still small relative to the
numbers of open-end funds and unit investment trusts
(discussed below), their size and
popularity are growing rapidly. In fact, the number of ETFs has
more than doubled to nearly 2,000 in the last decade. Many

ETFs are designed as index
funds, investing in a set of securities that mimic the
performance of a particular market index such as the S&P 500
Index, but with lower expenses and a
lower minimum required investment than for actively managed
funds. For these reasons, the financial press has been strongly
recommending this type of
fund, since it originated, for individual investors seeking
diversification and low costs. Investors who buy shares of an
ETF based on the S&P 500
(called a “Spider” because its ticker is SPY) will see an increa se
in the value of their shares when the S&P 500 Index increases
in value. Similarly,
investors in a “Diamond” (ticker DIA), an ETF based on the
Dow Jones Industrial Average, will benefit when the Dow goes
up. For investors who want
their portfolio to track large company stocks with low expenses,
either of these ETFs is a good choice.
Not all ETFs today are simple index funds. Specialized versions
include ETFs that use different trading strategies, such as
leverage, to magnify returns
(or losses), and those that track returns of much riskier asset
classes, such as cryptocurrencies or precious metals. As with
other investment company
types, the return and risk characteristics of ETFs are totally
dependent on the underlying portfolio.

Unit Investment Trusts
Another type of investment company is a unit investment trust
(UIT). A UIT buys and holds a fixed portfolio of securities for a
period of time that's
determined by the life of the investments in the trust (which
usually are fixed-maturity debt securities). Because there isn't
any change in the portfolio
over the period of investment, this type of fund is essentially
unmanaged. The manager of the pool, called the trustee,
initially purchases the pool of
investments and deposits them in a trust. Owners are issued
redeemable trust certificates, which entitle them to
proportionate shares of any income and
principal payments received by the trust and a distribution of
their proportionate share of the proceeds at the termination of
the trust.
The investors in a unit investment trust generally pay a
premium over what it costs the trustee to purchase the
underlying assets, providing the equivalent
of a commission to the trustee for his or her services (pooling
the funds and distributing the income and principal). Because
the funds are unmanaged,
the fee should be lower than that for a comparable managed
fund, but it still can be as high as 3 to 5 percent.
Why would an investor be willing to incur such a high cost? The
answer lies in the type of securities that make up unit
investment trusts. About 90
percent of these assets are fixed-income securities, primarily
municipal bonds. Each trust specializes in a certain type of
security, so one might hold only
municipal bonds and another only high-yield corporate bonds.
The high cost of individual bonds (usually $1,000 minimum)
makes it otherwise difficult
for individual investors to include these investment classes in
their portfolios. The availability of unit investment trust shares
means that small investors

can still participate in a relatively diversified pool of
specialized debt securities. Although there isn't an active
secondary market for the trust certificates,
the trustee will usually buy them back on request.
A unit investment trust continues in existence only as long as
assets remain in the trust. Thus, a trust invested in short-term
securities might exist for
only a few months, whereas a trust holding municipal bonds
might have a life of 20 years or more, depending on the
maturities of the bonds held. The
number of unit investment trusts and the total dollars invested
in them have remained relatively stable over the last decade.
Real Estate Investment Trusts
A real estate investment trust (REIT) is a special type of closed -
end fund that invests in real estate and mortgages. By law, a
REIT must have a buy-and-
hold investment strategy, a professional manager (the trustee),
and at least 100 shareholders. The trustee initially issues shares
and then uses the
investors' money to buy real estate assets according to the terms
of the trust, much like a unit investment trust. The difference is
that the REIT doesn't
have a limited life span, because most real estate investments
don't have fixed maturities. An important factor for individual
investors is that REITs must
distribute 90 percent of their profits to shareholders each year,

and this income will be taxable as ordinary income unless the
shares are held in a tax-
deferred account.
REITs offer individual investors the opportunity to diversify
their investment portfolios into real estate. Many investors
wouldn't otherwise have access
to this investment class because of the high initial investment
required and the liquidity risk involved. In many respects,
REITs are similar to stock
investments and closed-end mutual funds, trading on national
exchanges and distributing profits to the investors through
dividends. REITs often
specialize in particular types of real estate investments. Equity
REITs, which make up a large share of the market, specialize in
making direct
investments in income-producing real estate, such as office
buildings and shopping centers. Mortgage REITs focus on
mortgage investments, such as
residential and construction loans.
REITs can provide diversification for your portfolio because
their prices do not tend to go up and down at the same time as
stock and bond prices.
However, they aren't as liquid as stocks and are highly sensitive
to the real estate market environment. In the early 2000s, REIT
investors benefited from
the real estate bubble, earning higher returns than investors in
most other asset classes. But when real estate prices plummeted
later in the decade,
contributing to the 2008 financial crisis, REIT investors were
badly affected. As shown in Figure 13.1, the average equity
REIT lost about two-thirds of
its value between April 2007 and February 2009, much more
than the decline in the stock market over that period.
Fortunately for investors, as the
economy recovered and real estate prices stabilized, REIT
shares returned to their pre-2008 values.

Figure 13.1Equity REIT Total Return IndexREIT investors were
hard hit by the financial crisis, but the real estate market
rebounded strongly from 2009 to 2019. Source: FTSE NAREIT
U.S. Real Estate Index Series for Equity REITs, nareit.com.
Growth in the Market
Mutual fund investing by individuals has dramatically increased
over the last several decades. In 1980, fewer than 6 percent of
households owned
mutual fund shares. In 2018, as shown in Figure 13.2, nearly 44
percent were mutual fund investors, in large part due to the
growth in defined-
contribution retirement plans and IRAs. When asked why they
invest in mutual funds, 94 percent say they are saving for
retirement, and 48 percent say
they are saving for emergencies. Although the number of mutual
funds hasn't changed much, total investments have experienced
tremendous growth
since 1995, as shown in Table 13.1.
Figure 13.2Percentage of U.S. Households Owning Mutual
FundsAfter growing fast for several decades, the
proportion of households owning mutual funds has stabilized.
Source: Data from Investment Company Institute,
2019 Fact Book, www.ici.org.
Table13.1Growth in Number and Total Assets of U.S. Funds, by
Type of Investment Company

Open-end Funds Closed-end Funds Exchange-traded Funds Unit
Investment Trusts
Number of FundsAssets ($ billions)Number of FundsAssets ($
billions)Number of FundsAssets ($ billions)Number of
FundsAssets ($ billions)
1995 5,761 $2,811 499 $143 2 $1 12,979 $73
2000 8,370 6,965 481 143 80 66 10,072 74
2005 8,449 8,891 634 276 204 301 6,019 41
2010 8,536 11,833 624 238 950 992 5,971 51
Open-end Funds Closed-end Funds Exchange-traded Funds Unit
Investment Trusts
Number of FundsAssets ($ billions)Number of FundsAssets ($
billions)Number of FundsAssets ($ billions)Number of
FundsAssets ($ billions)
2015 9,517 15,652 559 261 1,644 2,101 5,188 94
2018 9,599 17,707 506 250 1,057 3,371 4,917 70
Source: Data from Investment Company Institute 2019
Factbook, www.ici.org.
Fund Classifications
Mutual funds are usually classified based on investment
objectives and portfolio composition. As the competition for
investors' dollars has grown,
mutual fund companies have attempted to distinguish

themselves from competitors, creating so much diversity that it
isn't always easy to categorize
funds. The classifications suggested in this section aren't
uniformly applied, but will familiarize you with the terms
commonly used to describe mutual
funds. In general, you'll find that the most important
distinctions among funds are the type of investment (equity
versus debt) and the investment
objective (income versus capital gain).
Classification by Investment Objective
Each mutual fund has a specific investment policy, which is
described in the fund's prospectus. For example, money market
mutual funds, introduced in
Chapter 3, consider the preservation of capital to be an
important investment objective. To achieve this objective, the
fund managers must invest in
short-term, low-risk debt securities. Investors know this in
advance and therefore have specific expectations about the
performance of this type of fund
based on its objective. The most common general investment
policy categories are capital appreciation (growth), income, and
preservation of capital, but
the objectives of a given fund may include more than one of
these.
Growth Funds
The primary objective of a growth fund is capital appreciation.
Managers attempt to select assets that will experience above-
average growth in value
over time. Because growing companies tend to be riskier than
stable companies, growth mutual funds are more appropriate for
investors who are willing
to bear a little more risk to achieve a higher long-run return.
Growth funds are often placed in subcategories depending on
the level and type of risk represented by the investment

portfolio. For example, an
aggressive growth fund invests only in risky companies that pay
no dividends, whereas a moderate growth fund, while still
focused on capital
appreciation, might invest in larger companies that pay stable
dividends but have the potential for good appreciation in value.
Aggressive growth funds,
as you'd expect, are much riskier and expose you to greater
potential losses in the event of a market downturn.
Income Funds
In contrast to a growth fund, an income fund holds stock and
bond investments that provide high current income, either in
dividends or interest. These
funds tend to be viewed as less risky than growth funds,
because the investor is realizing immediate gains rather than
taking the risk of waiting for future
gains. As with growth funds, there are various subcategories
within this group, most commonly based on the source of the
income (interest versus
dividends) and the risk level (high-quality debt versus junk
bonds).
Growth and Income Funds
Some funds try to straddle the fence, providing reasonable
income to investors while still investing in companies that have
good potential for growth in

value. Primarily invested in growth-oriented blue chip stocks,
these funds have generated respectable returns over time and
have been more stable than
the market as a whole.
Balanced Funds
A balanced fund, sometimes called a hybrid fund, provides
investors with the opportunity to benefit from investments in
both stocks and bonds. Because
they are better diversified than funds that are entirely invested
in stocks and because they tend to focus on high-grade
securities, balanced funds tend to
have stable returns over time. These funds are similar to income
funds but focus more on reducing investment risk.
Value Funds
A value fund invests in companies that its managers believe to
be currently undervalued by the market—companies with good
fundamentals whose
stock prices are low relative to their perceived potential. As
there are always many other investors seeking these same
undiscovered gems, the risk of
being wrong is fairly high. Value funds are a little less risky
than aggressive growth funds but still offer fairly good returns.
Life-Cycle and Target-Date Funds
A life-cycle fund allocates fund assets based on the age of the
investor. A fund for 30-year-olds will be invested in riskier
assets than a fund for 60-year-
olds. A target-date fund adjusts the portfolio allocation to meet
objectives related to a particular future need for cash, such as
retirement or education
funding. Funds of this type often have names like “Retirement
2040.” Generally, life-cycle and target-date funds attempt to
rebalance the portfolio to
gradually reduce risk as the investor gets older. If you're 30

years old, you could select a life-cycle fund that is designed for
your age group. However, if
you plan to retire earlier or later than average for your age
group, you might prefer a target-date fund instead. Given the
financial planning emphasis on
changing needs over the life cycle, the idea behind the design of
these types of funds is sound, although there isn't always
agreement on the optimal asset
mix.
The number and variety of life-cycle and target-date funds
increased substantially after the passage of the Pension
Protection Act of 2006, which
requires employers to offer a reasonable option to employees
who are automatically enrolled in an employer-sponsored
retirement plan. Because of their
simplicity for the investor, these funds have become very
popular choices for 401(k) plan assets. More than two-thirds of
401(k) plans now offer target-
date and life-cycle funds as investment options, and more than
50% of plan participants allocate at least some of their savings
to these funds.
Classification by Portfolio Composition
In addition to being classified by investment objective, funds
are also commonly categorized based on portfolio composition.
This can involve some
combination of asset class, industry representation, and index

benchmark.
Asset Class
Mutual funds commonly confine their investments to certain
asset classes, such as stocks versus bonds, although as we've
seen, some funds hold both
stocks and bonds. Within each broad asset class, funds may be
further classified according to such features as size of company
(large-cap, mid-cap, or
small-cap) or type of asset (long-term Treasury bonds, high-
grade corporate bonds, or municipal bonds). When you invest in
a mutual fund that is
concentrated in a particular asset class, the performance of your
fund is likely to mimic the overall performance of that asset
class. Your share values
will respond to economic conditions in much the same way as
do investments in individual stocks and bonds.
Industry or Sector
A sector fund specializes in a particular industry or business
sector, such as technology, financial services,
telecommunications, or health care. These
funds tend to focus on growth rather than income, and they
enable investors to allocate more of their money to the sector
believed to offer the most
attractive returns. Because this strategy results in less
diversification, sector funds tend to be riskier over time than
those that cover more industry
groups. For example, we saw earlier how REITs were stars in
the early 2000s but had bigger losses than investments in other
sectors during the financial
crisis.
Geographical Focus
When the U.S. stock market is down, investors can benefit from
global diversification. An international fund invests exclusively

in securities from other
countries. Some funds include securities from a particular
region, such as Latin America or Asia. Others, commonly
referred to as country funds,
specialize in securities from a particular country. In contrast, a
global fund attempts to diversify globally, investing in U.S. as
well as foreign securities.
Index Funds
Many managed funds try to mimic the performance of a
particular index, such as the S&P 500 Index, without
necessarily buying every stock that is
included in the index. The performance of such a fund is judged
by how well it compares with the performance of its benchmark
index. Many academic
studies, however, have shown that it's difficult for an actively
managed fund to beat its benchmark.
As an alternative, index funds attempt to buy and hold a
selection of stocks that can mimic the market more exactly and
at lower cost. If the index fund
is targeting the Dow Jones Industrial Average or the S&P 500
Index, for example, it will usually buy all the stocks in that
index in about the same
proportions and will therefore be able to track the index almost
exactly. For indexes that include a much larger number of
stocks, such as the New York
Stock Exchange Index, the index fund might try to buy a smaller
selection of representative stocks. Because index funds buy and
hold, trading costs and
fund expenses are minimized.

Socially Responsible Funds
If the “bottom line” is not your primary focus, you might be
interested in a socially responsible investing (SRI) fund. The
manager of an SRI fund is
charged with selecting stocks issued by companies that meet
some predefined ethical and moral standards. Although the
objectives of various funds
differ, common issues that are considered are a company's
policies toward employees and the environment. For this reason,
companies are commonly
rated based on ESG criteria (environmental, social, and
governance), making it easier for investors to identify
qualifying investments. SRI funds also
commonly avoid securities of companies that are involved in
“sin industries” such as tobacco, alcohol, and gambling. Note
that there are also socially
irresponsible funds (like the VICE Fund) that specificall y invest
in such industries.
Reflection Question 1
Is being a socially responsible investor important to you? Why
or why not?
You can use Interactive: Mutual Fund Classifications to review
the various types of mutual funds.
INTERACTIVE
See Interactive: Mutual Fund Classifications in WileyPLUS.
Copyright © 2019 John Wiley & Sons, Inc. All rights reserved.
2/15/2021 Investing in Stocks and Bonds

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12.1 Investing in Common Stock
LEARNING OBJECTIVE 12.1 LEARNING OBJECTIVE 12.1
Describe the characteristics and classifications of common
stock.
Before you consider investing in common stock, there's a lot
you need to know. Many beginning investors make the mistake
of jumping in without
really understanding what they're buying. If they're lucky, or if
the economy happens to be in a growth phase, their investment
portfolios might do well.
Unfortunately, inexperienced investors have too often lost their
life savings by making poorly-thought-out investment decisions.
What Is Common Stock?
You already know from Chapter 11 that when you buy shares of
stock, you're actually becoming a part owner of a business. You
wouldn't consider
buying into a local business, even if it was owned by your best
friend, without checking whether the business is in good
financial shape. Is it making a
profit? Does the company have the potential for future growth?
If you invest in the company, will you make a reasonable return
on your investment?
Your decision to buy shares of stock isn't really much different,
and it deserves the same careful deliberation. To evaluate your
stock investment
alternatives, you'll first need to understand the terminology
used by stock investors and the rights and obligations of
corporate stockholders.

Each share of common stock represents a proportionate share of
ownership in a corporation, equal to the number of shares
owned divided by the total
number of shares owned by all investors in the firm. A
corporation is a type of business organization that exists as a
legal entity separate from its
owners, the shareholders. The corporate form of organization
enables the company to have many owners with limited rights
and obligations. In contrast,
the owners of companies organized as sole proprietorships and
partnerships have more extensive rights (such as the ability to
directly participate in the
management of the business), but they also have greater
responsibility (such as personal liability for the debts of the
business).
Corporations can be classified as private or public. Shareholders
of private corporations do not buy or sell their shares. This
chapter focuses on publicly
traded companies whose stock can be bought and sold by
investors in the securities market.
Why Do Companies Issue Stock?
Even multibillion-dollar companies such as McDonald's, Inc.,
and Facebook, Inc., began as small private companies with only
a few owners. Those
owners eventually found it necessary to sell shares of stock to
the public to acquire the funds they needed to grow their
companies. After selling shares
to the public, the original owners have a smaller proportional
ownership interest in their companies, but they generally expect
their return on investment
to increase as a result of the expansion.
As a company continues to grow larger over time, it may again
need funds, which can come from current earnings, borrowed
funds, or the sale of
additional shares of stock. Most large publicly traded companies

have millions, or even billions of shares of stock outstanding,
so each individual share
represents only a very small ownership interest in the firm.
What Are the Rights and Obligations of Stock Ownership?
Investors who buy a company's stock are hoping to share in the
future income and growth of that company. Their investment
comes with very few
strings attached. Shareholders have limited rights to influence
the management of the firm, but they also have limited liability
for the firm's losses. This
section summarizes shareholders’ rights and obligations.
•Sharing the profits
In return for providing equity capital to the firm, a common
shareholder expects to share in the profits of the firm, either
through dividends or
through increases in the stock price. A common shareholder's
claim on the firm is said to be a residual claim. That means the
shareholder has a right
to share in the assets and income of the firm only after higher -
priority claims (such as interest payments on bonds) are
satisfied. If the firm's
revenues are greater than its expenses, the board of directors
can decide to distribute a cash dividend to the shareholders, or
it can decide to reinvest
the funds for future growth. Shareholders benefit in either case.
As a shareholder, if you receive dividend income, you have the

immediate benefit of
cash flow to spend or invest. Alternatively, if the firm reinvests
the money instead of distributing it to you, the value of your
shares should go up to
reflect the firm's new investment in its earning power and the
potential for future dividends. If you choose to sell at that
point, you'll realize a capital
gain—the difference between the price you get for your shares
and what you paid for them previously.
In some cases, a firm issues a stock dividend in place of a cash
dividend. Rather than receiving cash, you get additional shares
of the firm's stock in
proportion to the number of shares you already hold. While a
stock dividend doesn't immediately provide as much benefit as a
cash dividend or
capital gain, it has the potential to produce benefits in the
future. Because all stockholders receive these additional shares,
everyone's percentage of
ownership remains the same.
One of the risks of stock ownership is that firms are not
required to pay dividends to shareholders. Even if a firm has
issued dividends in the past, it
may choose to reduce or eliminate them in the future.
Conversely, firms that never issued dividends in the past may
decide to begin doing so. This
creates some inherent uncertainty, because you don't know in
advance just how much current income you'll earn on your
investment. You also take
the risk that the firm might go bankrupt, in which case you'll be
entitled only to a proportionate share of whatever is left over
after all the firm's
creditors are paid. But in return for bearing these risks,
shareholders have the opportunity for unlimited gain. If the firm
you've invested in does
poorly, you might lose all of your initial investment. But if it
does unusually well, you'll share in the bounty.

•Voting rights Each common stockholder has the right to vote
for members of the board of directors at an annual meeting. The
board is responsible
for selecting the top-level management of the firm and for
making major policy decisions. In general, corporations follow
a one-vote-per-share
system, so if you own 100 shares of a particular firm's stock,
you'll be able to cast 100 votes in the annual election. Of
course, your 100 votes won't
make a huge difference in the outcome of an election when
there are millions of shares outstanding. Often, a few
shareholders hold large blocks of
stock. Mark Zuckerberg, for example, owns about 12 million
Class A and 400 million Class B shares of Facebook, Inc.,
which gives him 53.3% of
the voting rights in the firm. If you own some shares, but can't
go to the annual meeting, you're allowed to pass your voting
right to someone else
through a written agreement called a proxy. Generally, the
current management team and opposing candidates will ask for
your proxy vote before the
election.
•Limited liability By state law, stockholders of corporations
have the important protection of limited liability, which means
that the most you can
lose when you own a share of stock is the value of the share
itself. Without the limited liability right, no one would be

willing to buy shares of stock,
because doing so would put their personal assets at risk of being
taken to pay for corporate debts in the event of company failure.
•Preemptive rights
When companies sell additional shares of stock, it's a bit like
cutting the same pizza into a larger number of smaller slices. If
you have only one
slice, you'll have less of the total pizza. Similarly, if you have
the same number of shares after the new stock is issued as you
had before, your
ownership interest in the company will be proportionately
smaller.
In some cases, shareholders are entitled to maintain their
proportionate interest in a company as the number of shares
outstanding increases with new
issues. This is called a preemptive right. For example, suppose
you own 100 shares in a company that currently has one million
shares outstanding.
If the company decides to issue another 250,000 shares, and if
you have preemptive rights, you'll be able to buy 25 shares of
the new issue before it
goes on sale to the public in order to maintain your current
percentage ownership
•Stock splits Corporations sometimes decide to declare a stock
split, which is similar to a stock dividend in that each
shareholder gets a number of
new shares in proportion to the number of shares already held.
The most frequent type of stock split is a two-for-one split, but
three-for-one or three-
for-two splits are also relatively common. The price of each
share usually adjusts so that the total value remains the same.
Interactive: How Are
Stock Splits Like Pizza Slices? illustrates this with an analogy
to slicing up a pizza.
INTERACTIVE

See Interactive: How Are Stock Splits Like Pizza Slices? in
WileyPLUS.
Investors tend to view a stock split as favorable information
about the company's prospects for future growth, so the
company's market value often
increases a little when a company announces a split. Why is a
split good news? The logic is that management likes to keep the
company's share price
below some maximum value perceived as affordable to the
company's investors. Announcement of a split is seen as a signal
that management expects
the stock price to continue to rise above this maximum value.
To the extent that this is news to investors, they'll respond by
buying the stock and driving
up the price.
If it has occurred to you that this stock price reaction might
create an opportunity to make a quick profit, you're not alone. A
lot of investors buy shares
just as the split announcement is made, hoping to sell them after
the company's value increases in response to the announcement
of the split. However,
market efficiency implies that any price change will occur
incredibly quickly. In fact, by the time you get your order in to
buy the shares after the split,
the price might have already gone up.
Advantages of Stock Investing
Chapter 11 introduced several of the advantages of investi ng as
an owner rather than as a lender: no management responsibility,
higher long-run returns,
greater liquidity, less sensitivity to interest, and the ability to
diversify a portfolio to reduce company-specific risk. Let's
explore these advantages and a

few others in a bit more detail.
No Management Responsibility
Stock investing allows you to participate in the profits of a firm
without having to contribute anything except money to the
venture. While you might
earn as much or more by starting your own business and
keeping all the profits for yourself, it would require a lot more
effort on your part. Your stock
ownership interest also protects you with limited liability—you
can never be held personally responsible for losses incurred as a
result of poor
management.
Higher Long-Run Returns
Recall that riskier assets usually earn a higher rate of return.
Over long time periods, large-company stocks have averaged a
12 percent return compared
with about 6 percent for Treasury bonds. How much would that
difference in investment return affect your long-term wealth
accumulation? You can use
your financial calculator to answer this question. Assume that
you plan to put $1,000 in an investment account today. What
will it be worth in 20 years if
you invest in government bonds, earn 6 percent interest, and
reinvest all your interest earnings? To find the answer, solve for
the future value of a lump
sum. With the financial calculator, you would enter and and
solve for This is the amount you'd have

in 20 years if you invested in government bonds. Now, what if
you invest in stocks instead and earn 12 percent per year? Using
the same method, you
can determine that your $1,000 investment will be worth $9,646
at the end of 20 years—almost three times as much. (If your
$1,000 is held in a taxable
account, the after-tax investment returns will be lower for both
asset classes.)
Even though stocks have yielded better returns than other
investments over time, there can be fairly big differences
between different stocks and over
different time periods. Figure 12.1 shows the stock price history
for two familiar companies, Walmart (WMT) and International
Business Machines Inc.
(IBM). Although both increased in value from 2009 to 2019,
WMT showed slow and steady growth, whereas IBM had a lot
more ups and downs. That's
because IBM is in a riskier industry. Technology companies are
more strongly affected by economic conditions than discount
department stores, which
have steady customers regardless of the state of the economy.
Figure 12.1Walmart and IBM Monthly Stock Prices, 2009-
2019Investors in both IBM and Walmart enjoyed the benefits of
a bull
stock market between 2009 and 2019.
Demonstration Problem 12.1 shows how you can compare the
rate of return on different investments.

DEMONSTRATION PROBLEM 12.1 Comparing Returns on
Different Stocks
Problem
Suppose you had $1,000 to invest at the beginning of 2009. At
that time, Walmart stock was priced at $37 per share and IBM
stock at $68 per share. If
these stocks grew in value to $95 and $133, respectively, by
January 1, 2019, including both capital gains and dividends,
would Walmart or IBM have
been the better investment?
Strategy
Calculate the rate of return for each stock for the 10 year period
to find the growth in value of your $1,000 investment in both
stocks. Because the prices
are already adjusted for dividends, we can simply look at the
change in each price over the period and then annualize it.
Liquidity
Another advantage of stocks is that they are fairly liquid
investments. As you know, a liquid asset is one that can be
converted to cash quickly without
loss of value. Bad news, such as a product recall that will cost
the firm millions of dollars, can cause a stock's value to decl ine
rapidly, so we wouldn't
place this asset in the same category as liquid savings and
checking accounts. However, you can usually sell shares of
stock quickly, easily, and at

relatively low cost. This is an important factor if you need cash
in a hurry.
Low Interest-Rate Sensitivity
Recall from Chapter 11 that the value of bonds and other debt
securities is highly influenced by interest rates, creating
interest-rate risk that increases
with the term to maturity on the bond. When rates go up, bond
prices fall, and vice versa. One of the advantages of stocks in a
portfolio is that stock
values are less sensitive to interest-rate movements. Even
though higher discount rates can reduce the present value of
future cash flows from stock
investments, there are often offsetting factors. For example, if
the reason interest rates are increasing is that the economy is in
an expansionary period of
the business cycle, the cash flows of the firm will increase as
well, so the value of the firm will not necessarily decline.
Diversifiable Risk
One of the fundamental principles of investing is that you can
lower your risk, as measured by variability of returns, by having
a variety of investments
in your portfolio. We introduced diversification in Chapter 11
in conjunction with the concept of asset allocation, because
holding several different asset
classes has a diversifying effect on your portfolio. But
diversification can reduce risk within asset classes as well, as
long as you select individual
investments that aren't too similar. If you hold a portfolio of
many different stocks, some of them will do well when others
are doing poorly. Holding a
number of stocks will therefore allow you to cancel out much of
the company-specific variability in returns. What you'll be left
with is market risk, the
risk that can't be diversified away because it comes from factors

common to all stocks.
ONLINE CALCULATOR DEMONSTRATION VIDEO
See Online Calculator Demonstration Video: Asset Allocation
in WileyPLUS.
As you saw above, the stock prices of both IBM and Walmart
increased in value between 2009 and 2019, despite being in
different sectors and having
different sensitivities to economic conditions. If you look
closely at the stock price chart in Figure 12.1, though, you can
see that the ups and downs of
the two companies’ share prices were often opposite each other
in a given month. This means that if you had owned shares of
both companies in your
portfolio, the IBM price declines would have been at least
partially offset by Walmart price increases.
Figure 12.2 compares $1,000 investments in IBM, WMT, and a
portfolio split equally between these two stocks over the years
2009-2019. You can see
that at first IBM outperformed WMT and the 50/50 portfolio,
though it began to lose value in 2013. By late 2014, all three
investments had
approximately doubled in value. Then IBM's value experienced
another decline, while WMT's value increased, a trend that
continued through 2019. The
50/50 portfolio ended up somewhere in the middle, earning an
annualized 8.6% over the 10-year period. Although investing in

the 50/50 portfolio
resulted in slightly lower accumulated value than investing in
Walmart stock alone, it also smoothed out some of the ups and
downs you would have
experienced if you had invested in only one of the stocks.
Figure 12.2The Effects of DiversificationInvesting in a 50/50
portfolio of WMT and IBM smoothed out some of the ups and
downs
associated with investing in only one of the stocks.
Disadvantages of Stock Investing
Although stock investing clearly offers some advantages for
long-run investors, it might not be for everyone. Investing in
stocks exposes you to
substantial risk that you cannot control, other than by selling
your shares if you don't like the actions taken by the
management of the company.
Depending on your personal risk preferences, financial goals,
and investment time horizon, you might not be willing or able
to bear this level of risk in
your portfolio.
Risk
An old saying warns, “If you can't take the heat, get out of the
kitchen.” Stock investors must be prepared to “take the heat” in
the form of ups and
downs in stock prices, as illustrated in Figure 12.3, which

shows the price history of the S&P 500 Index over a span of 21
years, from 1998 to 2019.
This was clearly a very volatile period for the stock market,
with terrorist attacks, a global financial crisis, and political
uncertainly resulting in two large
stock market declines and subsequent recoveries. Investors lost
about 40 percent of their wealth between 2000 and 2003,
regained it between 2003 and
2007, then lost even more between 2007 and 2008, recovering
again through 2014 and beyond.
The first decade of the 2000s was not kind to stock investors. In
fact, a diversified portfolio from the early peak in 2000 through
the end of 2012 would
have earned you a whopping 0 percent return for more than a
decade of investing. Clearly, this was not what investors
expected to happen based on prior
historical performance of the stock market. However, investors
who were in for the long haul saw their portfolios almost triple
in value between 1998
and 2019. This illustrates an important lesson about stock
investing—even though stocks may be a good long-term
investment, you'll have substantial
risk of ups and downs in the short term.
Figure 12.3S&P 500 Index, 1998-2019The stock market has
been on a roller coaster ride since the late 1990s.
No Control

We've already seen that, as a stock investor—particularly in a
large, publicly held corporation—you have little power to
influence the actions of
management. And management can do many things that cause
your share value to decline. Top managers can make business
decisions that increase the
company's risk or reduce its competitive advantage. Their
financial decisions might dilute your ownership interest if they
issue more shares or decrease
your residual interest if they take on more debt. In the extreme,
they may make self-interested decisions that line their own
pockets at your expense.
Even if you know what they're doing and object to it, you have
little recourse because your limited voting rights make it almost
impossible to effect any
managerial change. For this reason, it's commonly said that
stockholders “vote with their feet.” In other words, if you don't
like what management is
doing, you can walk away by selling your shares. Unfortunately,
by the time you know what's wrong, the value of the stock will
probably already reflect
the bad news, so you're likely to lose money.
Classification of Common Stock
Common stock is usually classified according to broad, and
sometimes overlapping, categories related to cash flow, risk,
and line of business. Although

these classifications have no official status, understanding the
common lingo used by investment professionals will help you to
better communicate with
financial advisors, make allocation decisions for your employer -
sponsored retirement plan, and comprehend what you read in the
financial press. An
important cautionary note if you are investing in individual
stocks rather than mutual funds: Companies differ widely from
one another, so it's always
important to analyze the individual companies independently
rather than to rely solely on these classifications to make
judgments about the suitability of
their stock for your portfolio. We look at some of the more
common classifications of common stocks in this section.
Income versus Growth Stocks
As previously discussed, investors usually expect to receive
some combination of current cash flow and price appreciation in
return for providing capital
to a firm. Stocks are often classified based on whether the
company tends to reward its investors primarily with current
income or with capital gains. An
income stock is one that pays investors a regular dividend rather
than concentrating on reinvestment of profits. Because these
stocks pay most of their
profits in dividends instead of reinvesting for future growth,
there is usually less capital appreciation. The relative certainty
of a dividend cash flow
stream makes these stocks attractive to more conservative stock
investors and to those who desire a regular income stream, such
as retirees.
A growth stock is one that compensates investors primarily
through increases in the value of the shares over time. Stocks
issued by younger companies
that are experiencing high growth in earnings and assets are
more likely to be classified as growth stocks. During a high-

growth phase, firms tend to
reinvest profits to meet capital needs rather than distribute
profits as dividends. Obviously, the attraction of growth stocks
to investors is the opportunity
to share in the future profits of these companies as investments
in growth eventually pay off. As you might expect, growth
stocks also expose investors
to greater uncertainty, because there are no guarantees that
today's reinvestment will translate into tomorrow's growth in
value. Younger investors who
have long investment time horizons are more likely to focus on
growth stocks, while investors who want investment income and
stability are less
inclined to invest in them.
Some growth stocks are highly risky—their prices fluctuate
widely, and they have very uncertain future prospects. Investors
in recent years have flocked
to buy Internet stocks, even when the companies were not yet
profitable. For every success story, such as Google, Facebook,
and Amazon, there are a
dozen failures—companies whose anticipated future profits
never materialized or were overestimated.
Blue Chip Stocks
A blue chip stock is one issued by a large, stable, mature
company. The earnings and growth of these multibillion-dollar
companies tend to track the
overall market. As consistent performers, they're considered
less risky than growth stocks; however, they don't offer
opportunities for unexpectedly high
returns. They are the slow and steady performers, often leaders
in their industry, and they commonly pay dividends in addition
to offering the
opportunity for some growth in value over time. Examples of
such companies include Anheuser-Busch, Procter & Gamble,
and Coca-Cola.

Cyclical versus Defensive Stocks
In the earlier example, we saw that IBM's stock price was more
sensitive to economic conditions than Walmart's stock price. A
cyclical stock exhibits
above-average sensitivity to the business cycle—that is, it tends
to perform well during strong economic climates and poorly in
downturns. Cyclical
companies include firms that produce consumer durable goods
and luxury items—automobiles, appliances, technology,
furniture, and sporting
equipment. Purchases of such goods can nearly always be put
off when money is tight. Companies connected to the home-
building industry (such as
Home Depot) and companies that provide services or goods to
other businesses (such as transportation and technology firms)
are also cyclical, because
during recessions, construction and investment projects tend to
be put on hold.
The opposite of a cyclical stock is a defensive stock, such as
Walmart stock, which is less sensitive to market ups and downs.
These stocks might still go
down in bear markets, but can be expected to lose less than
others. As a result, they can help to stabilize your portfolio
during market downturns. Stocks
that are related to food and beverages (Anheuser-Busch and
Coca-Cola) and to health care (Pfizer and CVS) are examples,

because they are in industries
that provide essential products and services that are in demand
regardless of economic conditions.
A measure commonly used to estimate the risk of stock
investments held in a diversified portfolio is the beta. A stock's
beta measures its market risk, as
discussed in Chapter 11, or how much it tends to move with the
overall market. The risk measured by beta is also sometimes
called nondiversifiable risk
because it's the risk that remains when you've already
diversified your portfolio. Cyclical stocks will usually have
higher betas, and defensive stocks will
have lower betas.
A beta equal to 1 means that the stock has the same degree of
volatility as the overall market and is expected to earn a similar
long-term rate of return if
held in a diversified portfolio. A beta less than 1 means that the
stock is less volatile than the market average and investors
should expect a
proportionally lower return. A beta greater than 1 means that
the stock is more volatile than average and should provide a
proportionally higher return.
Because most stocks tend to go up and down simultaneously
with the general market, just in different degrees, most beta
values are between 0.5 and 1.5,
and it is rare to find a stock with a negative beta.
Industry and Sector
Stocks are also categorized by the sector and industry of the
issuing companies. Table 12.1 provides sector classifications,
along with some examples of
representative companies and their industries. In this table, the
“sensitive” classification includes companies with average
sensitivity to the business
cycle. Industries in the financial services sector include banks
and insurance companies. Companies selling household and …

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